Capital Dividend Account: Changes to Note
The Institute for Advanced Financial Education (IAFE) releases a regular quarterly newsletter with updates and information important to members like JYC Financial. The below article, while undeniably dry, provides relevant information for corporate insurance policy owners.
The March 22, 2016 federal budget has resulted in significant changes to the credit to the capital dividend account arising upon the receipt of life insurance proceeds. While these proposals are not yet final, it is expected they will be enacted before the end of 2016 with certain retroactive effect.
The credit to the capital dividend account for the receipt of life insurance proceeds is found at paragraph (d) of the definition of “capital dividend account” in subsection 89(1) of the Income Tax Act (ITA).
In general terms, paragraph (d) of the definition of the “capital dividend account” is comprised of a series of components (subparagraphs i through vi) as follows:
Subparagraph (i) is the proceeds of a life insurance policy of which the corporation was a beneficiary on or before June 28, 1982 received by the corporation in the period and after 1971 in consequence of the death of any person.
Subparagraph (ii) is the proceeds of a life insurance policy (other than a “LIA policy” – leveraged insurance annuity policy) of which the corporation was not a beneficiary on or before June 28, 1982 received by the corporation in the period and after May 23, 1985 in consequence of the death of any person.
The June 28, 1982 and May 23, 1985 dates referenced above are to recognize that for a period of time there was the “life insurance capital dividend account” that tracked life insurance proceeds received by a corporation. This account ceased to track life insurance proceeds received by a corporation after May 23, 1985.
It is important to note that if a life insurance policy meets the definition of a LIA policy (as defined in subsection 148(1)), then the proceeds are not added to the capital dividend account.
Subparagraphs (i) and (ii) work together to add life insurance proceeds received by a corporation to its capital dividend account. This combined amount is then reduced by four amounts, three of which were amended by or introduced by the March 22, 2016 federal budget.
Subparagraph (iii), which in general terms reduces the CDA credit, has been amended to reflect the “adjusted cost basis of a policyholder’s interest in the policy immediately before death.” Previously this subparagraph reflected the adjusted cost basis of the policy to the corporation that was a beneficiary of the policy. Therefore, prior to this change, if the corporation receiving the proceeds was not the policy owner, there was no reduction to the credit arising from this component.
The new wording means that the policy’s adjusted cost basis will be used in the capital dividend account calculation even where the corporate beneficiary is not the owner of the policy.
The change to this provision creates some uncertainty in situations where there are multiple corporate beneficiaries of the same policy (i.e., such as a split dollar arrangement, shared ownership or split beneficiary designation). This now creates the question: does each beneficiary reduce their capital dividend account calculation by the entire policy’s adjusted cost basis, or a proportional amount based on the amount of life insurance proceeds received?
Subparagraph (iv) applies if the policy is a 10/8 policy (as defined in subsection 248(1)) and death occurs after 2013. It reduces the CDA credit by the amount of debt outstanding before death under the 10/8 policy arrangement. This paragraph was introduced in the 2013 budget designed to reduce the tax benefits associated with 10/8 policies.
Subparagraph (v) is new and will apply to life insurance proceeds received after March 21, 2016 where a policy was disposed of after 1999 and before March 22, 2016 by a policyholder (other than a taxable Canadian corporation) and subsection 148(7) applied to the transaction. In this situation, the amount by which the fair market value of the consideration, given in respect of the disposition, exceeds the greater of cash surrender value and adjusted cost basis of the policy interest immediately before the disposition will be used to reduce the credit to the capital dividend account.
Consider the example of Stan who transferred his life insurance policy to his company in 2005. At the time of the transfer, the policy had a cash surrender value of $50,000 and an adjusted cost basis of $75,000. Stan took back consideration of $200,000 from his corporation based on a fair market valuation from an independent actuary. At the time of transfer, subsection 148(7) of the ITA deemed Stan’s proceeds of disposition to be the policy’s cash surrender value, so Stan did not declare any income on the transaction because his adjusted cost basis was higher than the deemed proceeds.
New subparagraph (v) will reduce the capital dividend account credit by $125,000 when Stan’s company eventually receives the life insurance proceeds. This represents the amount by which Stan’s consideration of $200,000 exceeds the greater of cash surrender value ($50,000) and adjusted cost basis ($75,000) immediately before the transfer. The reduction caused by new paragraph (v) will be a fixed amount and will not vary over time. The information necessary to make this calculation will likely be available from the original transfer documents. This necessitates that information be preserved and made available to the tax professional, who will be calculating the company’s capital dividend account credit after the insurance proceeds are received.
Subparagraph (vi) is also new and applies to life insurance proceeds received after March 21, 2016, where the policy was disposed of after 1999 and before March 22, 2016 by a policyholder (other than a taxable Canadian corporation) and subsection 148(7) applied to the transaction. If this criterion applies, the credit to the company’s capital dividend account will be reduced by the amount by which the lesser of adjusted cost basis of the policy immediately before the transfer and fair market value of consideration received on the transfer exceeds the cash surrender value at the time of disposition of the policy, less the absolute value of the negative ACB at the time of death.
Continuing the example of Stan from above, this paragraph would result in an initial reduction in the credit to the capital dividend account of $25,000. This is the amount by which the lesser of adjusted cost basis ($75,000) and fair market value of consideration ($200,000) exceeds the cash surrender value ($50,000) at the time of transfer. This $25,000 amount can be reduced and possibly eliminated if the policy’s adjusted cost basis immediately before death has been reduced below zero because of the annual deduction of the net cost of pure insurance in the formula of the policy’s adjusted cost basis. These proposed changes create an essential need for accurate and long-term corporate record retention with respect to transactions over the policy’s lifetime.
It would be prudent for the corporate policyholder to retain these records, as such information will be required to properly determine the credit to the capital dividend account upon the receipt of the insurance proceeds. Such record keeping can certainly span many decades over the life of the policy.